No “Dumbing Down” Allowed—Asset Allocation Effectively Explains Key Concepts
By Paul E. Lacko
A book titled Asset Allocation for Dummies was published a couple months ago. The authors are Jerry A. Miccolis and Dorianne R. Perrucci. Jerry, as you probably know, is a Fellow of the Casualty Actuarial Society with many years’ experience in the field of enterprise risk management long before most of us even recognized ERM as a field or thought of making it a syllabus topic. Jerry also has earned professional accreditations as an investment advisor.
Jerry is the professional investment expert. Dorianne is the professional financial writer. Together, they make a good team. Jerry’s actuarial background and his experience in risk management both come across in the structure of the material and the commentary.
I have not finished the book, but I already want to recommend it to you. Although the book may be intended for “dummies,” it is not exactly light reading. The authors present an almost-overwhelming amount of information. Fortunately, they skip needless detail and summarize important concepts effectively. The early chapters paint a complete picture of how to invest and come out ahead. The later chapters hand you the paintbrush and put you to work.
As an experienced actuary, you already have everything you need to work through the exercises in the later chapters and develop your asset allocation plan. You can calculate means, standard deviations, and correlation coefficients—or your spreadsheet can—and you understand the concept of “efficient frontier.” This puts you several steps ahead of the average “dummy,” who encounters this material for the first time when he picks up this book.
As an average “dummy” myself in the mid-1980s, I bought and read at least a dozen books about financial markets and personal investing. The one book that most appealed to me at the time presented a simple, straight-forward plan based on statistical analysis of historical experience in the financial markets. The plan was to invest an equal amount of money in each of four different asset classes that were volatile and negatively correlated, and subsequently to move money from one asset class to another so as to maintain that even distribution of total assets among the asset classes over time.
The author, Harry Browne, recommended a money market fund, gold, long-term bonds, and a diversified portfolio of stocks. The earnings in the money market fund would increase when short-term interest rates rose and maintain value during a recession. The dollar price of gold would increase with the inflation rate and increase if the value of the dollar declined against foreign currencies. The zero-coupon bonds would be worth more if interest rates dropped during a period of deflation. And the value of the stock portfolio would increase so long as the economy kept humming along while interest rates, inflation, and the value of the dollar maintained steady levels.
Periodic rebalancing took advantage of four characteristics that are apparent to anyone familiar with market behavior (or the insurance business cycle). First, no appreciating asset class appreciates forever. Second, a “risk-free” return will be outdone over time by inflation. Third, what goes up slowly and steadily for a long time will sometimes crash. Fourth, even when a crash seems inevitable, it’s exact timing is unpredictable.
Each asset class has a history of winning under certain conditions. More than two asset classes are highly unlikely to be winners during any single stretch of time. Even experts can’t consistently predict when winners will turn into losers (and vice versa). Browne advised the investor simply to watch the accumulated balances in each asset class, and whenever one class grew to more than 30% of the total (current) value of the entire portfolio, move money among the classes to reestablish the equal value invested in each asset class. Some of the gains from today’s winners would thereby be shifted to tomorrow’s winners, and the winnings would grow over time.
With a long enough investment horizon and sufficiently volatile markets, you almost have to come out ahead. Rebalancing takes some discipline, but it makes the expected return of the total investment portfolio much higher than the expected return of any single asset class, and it makes the standard deviation of the total portfolio returns over time quite low compared to any of the four volatile asset classes.
Good plan. Sound reasoning. Slow and steady wins the race. I applied a slight variation of Harry Browne’s plan to my IRA funds back then, and the results over twenty years were as predicted. (I have also tried other investment plans, including investing without a plan, and none worked very well at all. Live and learn.)
Jerry and Dorianne and recommend the same general approach: diversify among several asset classes with uncorrelated or negatively correlated returns and rebalance according to a predetermined schedule. The authors expose the reader to a broad range of investment classes, many of which were not easily obtained by individual investors 25 years ago or did not even exist then.
Investing today can be as complicated as you care to make it. There are many more asset classes now than ever before, and the variety keeps growing. In the early 1980s, sector mutual funds were relatively new creations, and options on commodity futures were considered exotic. Now, we’re all at least a little familiar with concepts such as securitized debt, derivative securities, and derivatives of derivative securities.
Financial engineers now design products that are intended to match specific risk/return characteristics, and these are available to individual investors. Do you want a financial asset with two or three times the volatility of some underlying stock portfolio? You can actually get it. (It’s amazing to me what some people can do with computers.)
The longer your investment horizon, the greater the risk you can tolerate and the higher the returns you can shoot for. Asset Allocation for Dummies explains how to determine your time frame, invest accordingly, and meet your financial goals. Your investment horizon may be much longer than you think.
Please send us a postcard after you settle into a comfortable spot along the efficient frontier!
Asset Location for Dummies by Jerry A. Miccolis and Dorianne Perucci (For Dummies, 2009, $24.99) Postcript: A few days after I wrote this, an article about—you guessed it—asset allocation strategies appeared on the front page of the Wall Street Journal. “The financial crisis has sent many financial advisers, academics and investors back to the drawing board,” reported Tom Lauricella in his report titled “Failure of a Fail-Safe Strategy Sends Investors Scrambling.” He wrote that “a number of influential analysts, from managers of massive funds…to those at small school endowments, argue that asset-allocation strategies are fundamentally flawed.” These analysts “contend that the problems warrant rethinking those relationships [between asset classes] to account for broad changes in the global economy and financial innovations that change the way people invest.” In short, a lot of experts lost a lot of money in 2008 despite all their charts of historical correlation coefficients, volatility measures, and risk/reward trade-offs. Was this a short-term anomaly due to an extreme event? Your guess is as good as theirs.